More About the Tax Cuts & Jobs Act For Pass-Through Entities

(Originally posted 02/12/2018)

Back on January 19th, when we discussed whether the new tax law is more friendly to C Corps or S Corps, we touched on the pass-through aspect of an S Corp. Looking at that rule by itself, though, you should be aware that we used one example, but your situation could face a different set of criteria.

This is, perhaps, the most complicated feature of the Tax Cuts & Jobs Act. Due to this complexity, implementing this deduction will require additional clarification—either from Congress or the IRS. We’ll stay on top of this issue, so we can address the specific circumstances of our clients on an individual basis.

Basically, the new tax law has changed business entity taxation dramatically. For C Corporations, the tax rate was reduced from a maximum rate of 35% to a flat rate of 21%. That’s a relatively easy calculation for you and your CPA if you’re a C Corp.

However, for S-Corporations, LLCs, and partnerships organized for pass-through income to your personal return, the law has created an involved set of new rules that may provide a deduction of up to 20% of the taxable income from that entity, but not necessarily.

As noted, the law is complicated, so this is an overview of what we’re facing; it’s by no means an exhaustive analysis of the nuances of the law.

First off, the provisions of the law address two types of businesses: 1) a specified service trade or business; and, 2) a qualified trade or business.

A specified service or trade is any entity involving performance in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners, or one that involves investment management, trading, or dealing.

A qualified trade or business is any business that does not meet the definition of a specifiedservice or trade; a retailer, manufacturer, or building contractor, for example.

Below is how the deduction for these types of businesses is computed for pass-through entities.

Specified Service or Trade

Taxpayers who meet the definition of a specified service or trade will be subject to one of the following three scenarios:

Scenario 1

Taxpayers with taxable income equal to or greater than $207,500 (or $415,000 with a joint return) will have the entire potential deduction phased out and will receive no benefit.

Scenario 2

Taxpayers with taxable income greater than $157,500 ($315,000 with a joint return) but below $207,500 (or $415,000 on a joint return) will receive a limited deduction. The 20% deduction will be reduced by the percentage equal to the ratio of the excess of the taxable income of the taxpayer over the threshold amount divided by $50,000 ($100,000 on a joint return).

Scenario 3

Taxpayers with taxable income below $157,500 ($315,000 on a joint return) will receive a deduction for the lesser of: (a) 20% of the specified service trade or business income with respect to each business, or (b) greater of either 50% of the W-2 wages with respect to the business or the sum of 25% of the W-2 wages and 2.5% of the unadjusted basis of all qualified property.

Qualified Trade or Business

Taxpayers who meet the definition of qualified trade or business will be subject to one of the following three scenarios:

Scenario 1

Taxpayers with taxable income equal to or greater than $207,500 ($415,000 on a joint return) will receive a deduction for the lesser of: (a) 20% of the qualified trade or business income with respect to each business, or (b) the greater of 50% of the W-2 wages with respect to the business or the sum of 25% of the W-2 wages and 2.5% of the unadjusted basis of all qualified property.

Scenario 2

Taxpayers with taxable income greater than $157,500 ($315,000 on a joint return) but below $207,500 ($415,000 on a joint return) the wage and property limitations will be phased in and potentially partially limit the 20% deduction.

Scenario 3

Taxpayers with taxable income below $157,500 ($315,000 on a joint return) will receive a deduction equal to 20% of the income from the qualified trade or business with no limitation based upon the wages or basis of the property.

Conclusion

Determining your pass-through deduction is a new and somewhat intricate calculation that will require careful consideration when it comes time to prepare your tax return.